Can the Market Hold On Amid Wave of Falling Profits?

The third quarter is the first in three years, where profits are actually declining, and the stock market is taking notice.

As of Friday, earnings for the S&P 500 companies were expected to be off 1.8 percent for the quarter. In the coming week, more than 150 of the S&P are reporting, including Apple, Caterpillar, Boeing, Amazon.com, Merck, and AT&T. Earnings news will dominate, but there is also a two-day Fed meeting; the final presidential debate Monday, and important economic reports that include housing data and the first look at third-quarter GDP.

Earnings to Watch

"Earnings, earnings, earnings — that's what we're focused on," said Patrick Boyle, CRT Capital managing director. "We were focused on earnings coming into this week and last week, and right now it's just letting us down." (Read more:Earnings 'Stink' So Far but Stock Selloff May Be Limited)

"You've got to be a little nervous going into next week," said Boyle. But, he adds, because the market is "backstopped" by the Federal Reserve and European Central Bank "people want to buy the dips."

The S&P was up 0.3 percent for the week, at 1433, right at its 50-day moving average, while the Dow was off 0.1 percent at 13,343. The Nasdaq, hit by tech's selloff, lost 1.3 percent for the week to 3005. The S&P tech sector was down 2.4 percent, while materials were the best performers, up 2.1 percent.

Materials companies were expected to perform poorly this quarter but expectations for the technology sector had not come down as much and many investors were more heavily invested in tech than other sectors. Therefore, the selling by disappointed investors has been dramatic. Since the S&P's Sept. 14, 2012 high, tech has by far been the biggest laggard, losing 7.8 percent. Materials stocks were the second worse sector since then, down 2.9 percent, and energy was third, down 2. 8 percent.

"I would say this is just the beginning," said Carter Worth, Oppenheimer Asset Management's chief market technician. He said he expects another two- to three-percent decline, with the S&P heading to its 150-day moving average at 1380. Then, its direction remains to be seen.

"My bet is down. When we get there, it's how you go down there. If we were going to crash there (150-day) on Monday, I'd say we go lower," said Worth. In a note earlier in the week, Worth had identified the tech sector as heading for trouble. He said semiconductors and semiconductor-equipment makers were "literally coming apart." He also pointed out that some leading names, like Qualcomm, Apple, Microsoft nd Amazon were under pressure.

Under Pressure

But the tech space might see some excitement this week when Apple unveils its new iPad mini. Microsoft also launches Windows 8, and its new Surface tablet product.

Floor Under Stocks

Even with the bumpy earnings season, strategists say there are plenty of underpinnings for the market, including the already baked-in expectations that earnings would be weak. "The institutional clients know the estimates are too high, so the missing of those estimates is not going to be disruptive in the aggregate. Individual companies could still have some strong volatility. Individual stocks will still get whipsawed sometimes," said Tobias Levkovich, chief U.S. equity strategist at Citigroup.

J.P. Morgan strategist Thomas Lee sees a trough in the third- or fourth-quarter profit reports, and the current reports are only revealing what the market about a slowdown in the global economy. "We know the global data's been really, really sluggish, and so that's the reason why industrial and tech earnings are as weak as they are," he said. Lee said there are signs that investors have been buying stocks on dips that sold off on earnings news. That, he said, is a sign the earnings misses are already factored in to share prices.

Lee said the fact that so many managers are lagging the indexes this year could also give a boost to the market this quarter. "They're really trying to close this gap. They roughly have 10 weeks to fix that," he said. "That's the opportunity that people will use to buy on pullbacks. The market's down. I know earnings are kind of scaring people but from a hedge fund perspective, once you're done with earnings, you are through a negative catalyst." He said he thinks the election could be a factor for the market, but a re-election of President Barack Obama is already priced in. However, a Mitt Romney victory could ignite a bigger rally. (Read more: Will Final Obama-Romney Debate Be a Game Changer?)

Levkovich said he sees a similar trend, with most institutions not meeting the benchmarks because they stayed defensive too long. "We see two different kinds of views. Some people are saying: 'I've made some money, let's lock in the gains.' Others are saying 'I see a big fourth quarter rally. Let's gear up,'" he said. "The bias is a little more bullish than it is cautious."

Mark Luschini, chief investment strategist at Janney Montgomery, said he's trusting the market's rally a little more recently. He had been looking for improvement in economic indicators, and some of that is beginning to show up. "In the last couple of weeks, you had ISM move above the boom-bust line. You had auto sales above 14 million. You had retail sales better than expected. You had the improvement in the housing recovery and that's a real green shoot," he said.

Add to that improvement in some of China's data this past week, he said. "It doesn't spell a vigorous turnabout in the economy, but at the same time it suggests the deterioration we had been seeing has been stemmed and validates why equity prices are supported at these levels," he said.

Fed Ahead

The Fed's easy policies are another reason traders say stock prices are supported. The Fed is continuing its "Operation Twist," where it buys long-dated Treasury securities and sells the short end. It is also conducting an open-ended QE3 mortgage-purchase program, announced at its last meeting.

Fed watchers are not expecting any action at this week's meeting. "It's likely to be an inconsequential meeting, a transition meeting," said Pimco strategist Tony Crescenzi.

"The December meeting is the one with the greater likelihood of fireworks because there are decisions to be made," he said. "The key decision to be made is whether to continue the purchase of longer term securities, after Operation Twist ends. Second is whether to change the forward guidance (on rates) and move it away from calendar guidance, which many members do not like."